EDITORIAL: Reality check for yuan derivatives

Two weeks ago, the Financial Supervisory Commission announced that it was banning Bank SinoPac from selling Target Redemption Forwards (TRFs) — a structured financial derivative — for a year, citing the lender’s history of misselling products and its resulting disputes with customers.

It is the strictest punishment the commission has handed out over a financial product sold by a bank since it was established in 2004; much more severe than the nine-month ban on certain investment trust businesses that it meted out to several banks in 2008 for misselling structured notes linked to bankrupt Lehman Brothers Holdings.

A TRF is a complex set of currency-linked option products classified as a type of Treasury Marketing Unit (TMU) business, which has seen solid growth over the past two years and had increased efects on banks’ earnings in the domestic low interest rate environment.

Among the foreign currency-denominated options, yuan-based TRFs have been selling like hot cakes over the past two years, during which the Chinese currency appreciated strongly and corporate investors bought currency hedging products intending to manage fluctuations in foreign exchange rates, while earning extra income by betting on the yuan to stay strong.

The yuan’s one-way appreciation over this period has enabled banks to enjoy robust growth in their TMU businesses. Conversely, the yuan’s weakness this year has prompted a rapid slowdown in speculative demand of the currency and its continued decline has forced a number of corporate investors to either book losses or sell their holdings to meet margin calls.

TRFs have exposed the risks of derivative products denominated in yuan and that is why the commission wants to put a brake on their sale. Last week, the commission reiterated that it might soon sanction more banks over TRF disputes or ban other structured products.

The issues around TRFs are not the result of flawed product design, but of a market in which bank employees are not properly trained to sell the products and corporate executives are blinded by greed. Therefore the commission is sending the message that banks face severe punishment for selling customers complicated derivative products without full disclosure of the investment risks, the likelihood of over-leveraging and potential exit costs involved.

The regulator is also imposing the penalty on Bank SinoPac to warn all banks from selling derivative products based primarily on rewards and incentives for bank employees rather than customers’ real hedging needs.

However, with preferential interest rates reaching 3 percent or higher, yuan deposits in Taiwan have increased by about 14 billion yuan (US$2.3 billion) per month since February last year, when banks started to accept deposits and make loans in the Chinese currency. As of the end of March, there was 268.39 billion yuan saved in Taiwanese accounts.

Given the yuan’s sharp fall in recent months, the commission is hoping that current market conditions could serve as a reality check — not just for individual investors in TRFs, but for all market participants — about the credit risks these instruments carry.

The commission has not provided estimates of how many corporate investors were involved in the missold TRFs, what are the likely mark-to-market losses for holders of the derivative products, or how much it would cost banks to redress their malpractice. As the commission investigates these matters, it should also push for market discipline in the banking industry and help ease investors’ worries about potential losses.